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Following the trend diversified managed futures trading

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Contents
Cover
Title Page
Copyright
Dedication
Foreword
Preface
WHY WRITE A BOOK?
Acknowledgements
Chapter 1: Cross-Asset Trend Following with Futures
DIVERSIFIED TREND FOLLOWING IN A NUTSHELL
THE TRADITIONAL INVESTMENT APPROACH
THE CASE FOR DIVERSIFIED MANAGED FUTURES
CRITICISM OF TREND-FOLLOWING STRATEGIES
MANAGED FUTURES AS A BUSINESS
DIFFERENCES BETWEEN RUNNING A TRADING
BUSINESS AND PERSONAL TRADING
Chapter 2: Futures Data and Tools
FUTURES AS AN ASSET CLASS
FUTURES DATA
FUTURES SECTORS
REQUIRED TOOLS
Chapter 3: Constructing Diversified Futures Trading Strategies


THEY ARE ALL DOING THE SAME THING
CRACKING OPEN THE MAGIC TREND-FOLLOWING BLACK
BOX
Chapter 4: Two Basic Trend-Following Strategies
STRATEGY PERFORMANCE


IMPROVING THE STRATEGIES
Chapter 5: In-Depth Analysis of Trend-Following Performance
STRATEGY BEHAVIOUR
AS A COMPLEMENT TO AN EQUITY PORTFOLIO
TRADING DIRECTION
SECTOR IMPACT
CASH MANAGEMENT AND THE EFFECT OF FREE
GOVERNMENT MONEY
PUTTING LEVERAGE INTO CONTEXT
Chapter 6: Year by Year Review
HOW TO READ THIS CHAPTER
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000


2001
2002
2003
2004
2005
2006

2007
2008
2009
2010
2011
CONCLUSIONS OF YEAR BY YEAR REVIEW
Chapter 7: Reverse Engineering the Competition
INVESTMENT UNIVERSES
COMPARING THE INVESTMENT UNIVERSES
REPLICATING EXISTING FUNDS
CONCLUSIONS
Chapter 8: Tweaks and Improvements
TRADING MULTIPLE TIME FRAMES
TRADING SYNTHETIC CONTRACTS
ADDING A COUNTER-TREND COMPONENT
INTRADAY STOPS
CORRELATION MATRICES, POSITION SIZING AND RISK
THE ROLLOVER EFFECT
OPTIMISATION AND ITS DISCONTENTS
Chapter 9: Practicalities of Futures Trading
REQUIRED ASSET BASE


GOING LIVE
EXECUTION
CASH MANAGEMENT
HIGHER VOLATILITY IN DRAWDOWN MODE
PORTFOLIO MONITORING
STRATEGY FOLLOW-UP
Chapter 10: Final Words of Caution

DIMINISHING RETURNS OF FUTURES FUNDS
ENDING UP IN THE SOUP BOWL
SETTING THE INITIAL RISK LEVEL
Bibliography
OFFICIAL BOOK WEBSITE
RESEARCH PAPERS, ARTICLES AND WEBSITES
BOOKS
Index



© 2013 Andreas F. Clenow
Registered office
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A catalogue record for this book is available from the British Library.
ISBN 978-1-118-41085-1 (hbk) ISBN 978-1-118-41082-0 (ebk)
ISBN 978-1-118-41083-7 (ebk) ISBN 978-1-118-41084-4 (ebk)


To my wonderful wife Eng Cheng and my son Brandon
for their love and patience


Foreword
This book is an excellent training manual for anyone interested in learning how to make money as a
trend follower.
I know a bit about trend following because I was part of the famous Turtle experiment in the 1980s
when Richard Dennis, the Prince of the Pits, showed the world that trading could be taught and that
people with the right sort of training and perspective could make consistent returns that far exceeded
normal investments. Ultimately, that ordinary people could learn to trade like the most successful
hedge funds. I started as a 19-year-old kid and by the time I was 24 in 1987, I took home $8 million,
which was my cut of the $31.5 million I earned for Richard Dennis as a trend follower.
I even wrote a book about it, Way of the Turtle . It became a bestseller because many traders
wanted to know the secrets of our success and to hear about the story first-hand which had been kept

secret because of confidentiality agreements and our loyalty to Richard Dennis, a great man and a
trading legend.
I’d thought about writing a follow-on book a few times in the intervening years; something meatier
and with more detail. My book was part-story and part-trading manual and I thought about writing a
book that was all trading manual.
In Following the Trend, Andreas Clenow has written a trend-following trading manual I would be
proud to put my own name on. I’m very picky too, so I don’t say this lightly.
Very few trading books are worthy of an endorsement of any sort. Too many are filled with tips and
tricks that don’t stand the test of the markets, let alone the test of time. Too many are written by those
who are trying to sell you something like a course, or their seminars. Too many want your money
more than they want to create an excellent book.
That’s why I don’t often speak at conferences and you won’t see me endorsing many books. There
is too much self-serving propaganda in the trading industry that makes its money by fleecing the
unsuspecting newcomers; too many lies designed to rope in the neophytes with promises of easy
profits and quick money that will never pan out.
Following the Trend is different.
It is solid, clearly written, covers all the basics, and it doesn’t promise you anything that you can’t
actually get as a trend follower.
If you want to be a trend follower, first, read Reminiscences of a Stock Operator to learn from
Jesse Livermore. Then, buy Jack Schwager’s Market Wizards books to learn about the great traders
who have been trend followers, like Richard Dennis my trading mentor, Ed Seykota, Bill Dunn, John
W. Henry, and Richard Donchian. They will get you excited about the possibilities but leave you
wondering how; how can you too learn to be a trend follower?
Then, when you are ready to move from desire to reality. When you are ready to do it yourself. To
make your own mark.
Read Following the Trend.


Curtis Faith
Savannah, GA U.S.A.



Preface
This book is in essence about a single trading strategy based on a concept that has been publically
known for at least two decades. It is a strategy that has worked remarkably well for over 30 years
with a large number of hedge funds employing it. This strategy has been given much attention over the
past few years and in particular after the dramatically positive returns it generated in 2008, but it
seems nevertheless to be constantly misunderstood, misinterpreted and misused. Even worse, various
flawed and overly complicated iterations of it are all too often sold for large amounts of money by
people who have never even traded them in a professional environment. The strategy I am alluding to
goes by many names but it is in essence the same strategy that most trend-following futures managers
(or CTAs for Commodity Trading Advisors if you prefer) have been trading for many years.
This book differs in many ways from the more traditional way in which trading literature tends to
approach the subject of trend-following strategies. My primary reason for writing this book is to fill a
gap in that literature and to make publicly available analyses and information that is already known
by successful diversified trend followers, but understood by few not already in this very specialised
part of the business. It is my belief that most books and therefore most people aspiring to get into this
business are focusing on the wrong things, such as entry and exit rules, and missing the important
aspects. This is likely related to the fact that many authors don’t actually design or trade these
strategies for a living.
There have been many famous star traders in this particular part of the industry and some of them
have been raised to almost mythical status and seen as kinds of deities in the business. These people
have my highest respect for their success and pioneer work in our field, but this book is not about
hero worship and it does not dwell on strategies that worked in the 1970s but might be financial
suicide to run in the same shape today. The market has changed and even more so the hedge-fund
industry and I intend to focus on what I see as viable strategies in the current financial marketplace.
This is not a text book where every possible strategy and indicator is explored in depth with
comparisons of the pros and cons of exponential moving average to simple moving average, to
adaptive moving average and so on. I don’t describe every trading indicator I can think of or invent
new ones and name them after myself. You don’t need a whole bag of technical indicators to construct

a solid trend-following strategy and it certainly does not add anything to the field if I change a few
details of some formula and call the new one by my own name, although I have to admit that ‘The
Clenow Oscillator’ does have a certain ring to it. Indicators are not important and focusing on these
details is likely to be the easiest way to miss the whole plot and get stuck in nonsense curve fitting
and over-optimisations. I intend to do the absolute opposite and use only the most basic methods and
indicators to show how you can construct strategies good enough to use in professional hedge funds
without having unnecessary complexity. The buy and sell rules are the least important part of a
strategy and focusing on them would serve only to distract from where the real value comes.
Also, this is not a get-rich-quick book. If you are looking for a quick and easy way to get rich you
need to look elsewhere. One of my main points in this book is that it is not terribly difficult to create a
trading strategy that can rival many large futures hedge funds but that absolutely does not mean that
this is an easy business. Creating a trading strategy is only one step out of many and I even provide


trading rules in this book that perform very well over time and have return profiles that are
marketable to seasoned institutional investors. That is only part of the work though and if you don’t do
your homework properly you will most likely end up either not getting any investments in the first
place or blowing up your own and your investors’ money at the first sign of market trouble.
To be able to use the knowledge I pass on here, you need to put in some really hard work. Don’t
take anyone’s word when it comes to trading strategies, not even mine. You need to invest in a good
market data infrastructure including effective simulation software and study a proper programming
language if you don’t already know one. Then you can start replicating the strategies I describe here
and make up your own mind about their usefulness, and I hope find ways to improve them and adapt
to your own desired level of risk and return. Using someone else’s method out of the box is rarely a
good idea and you need to make the strategies your own in order to really know and trust them.
Even after you reach that stage, you have most of the work ahead of you. Trading these strategies on
a daily basis is a lot tougher than most people expect, not least from a psychological point of view.
Add the task of finding investors, launching a fund or managed accounts setup, running the business
side, reporting, mid office and so on, and you soon realise that this is not a get-rich-quick scheme. It
is certainly a highly rewarding business to be in if you are good at what you do, but that does not

mean it is either easy or quick.
So despite the stated fact that this book is essentially about a single strategy, I will demonstrate that
this one strategy is sufficient to replicate the top trend-following hedge funds of the world, when you
fully understand it.

WHY WRITE A BOOK?
Practically no managed futures funds will reveal their trading rules and they tend to treat their
proprietary strategy as if they were blueprints for nuclear weapons. They do so for good reason but
not necessarily for the reason most people would assume. The most important rationale for the whole
secrecy business is likely tied to marketing, and the perception of a fund manager possessing the
secret formula to make gold out of stone will certainly help to sell the fund as a unique opportunity.
The fact of the matter is that although most professional trend followers have their proprietary
tweaks, the core strategies used don’t differ very much in this business. That might sound like an odd
statement, since I have obviously not been privy to the source code of all the managed futures funds
out there and because they sometimes show quite different return profiles it would seem as if they are
doing very different things. However, by using very simplistic methods one can replicate very closely
the returns of many CTA funds and by tweaking the time horizons, risk factor and investment universe
one can replicate most of them.
This is not to say that these funds are not good or that they don’t have their own valuable
proprietary algorithms. The point is merely that the specific tweaks used by each shop are only a
small factor and that the bulk of the returns come from fairly simple models. Early on in this book I
show two basic strategies and how even these highly simplistic models are able to explain a large
part of CTA returns, and I then go on to refine these two strategies into one strategy that can compete
well with the big established futures funds. I show all the details of how this is done, enabling the
reader to replicate the same strategies. These strategies are tradable with quite attractive return


profiles just as they are and I show in subsequent chapters how to improve upon them further. I intend
to show not just simple examples but complete strategies that can be used straight away for
institutional money management.

And why would I go and tell you all of this? Wouldn’t the spread of this knowledge cause all trendfollowing strategies to cease functioning; free money would be given to the unwashed masses instead
of the secret guild of hedge-fund managers and make the earth suddenly stop revolving and fling us all
out into space? Well, there are many reasons quantitative traders give to justify their secrecy and keep
the mystique up and a few of them are even valid, but in the case of trend-following futures I don’t see
too much of a downside in letting others in on the game. The trend-following game is currently
dominated by a group of massive funds with assets in the order of US$5–25 billion, which they
leverage many times over to play futures all over the world. These fund managers know everything I
write in this book and plenty more. The idea that me writing this book may cause so many people to
go into the trend-following futures business that their trades would somehow overshadow the big
players and destroy the investment opportunities is a nice one for my ego, but not a very probable
one. What I describe here is already done on a massive scale and if a few of my readers decide to go
into this field, good for them and I wish them the best of luck.
What we are talking about here are simply methods to locate medium- to long-term trends typically
caused by real economic developments and to systematically make money from them over time.
Having more people doing the same will hardly change the real economic behaviour of humankind
that is ultimately behind the price action. One could of course argue that a significant increase in
assets in this game could make the exact entries and exits more of a problem, causing big moves when
the crowd enters or exits at the same time. That is a concern for sure, but not a major one.
Overcoming these kinds of problems resides in the small details of the strategies and will have little
impact over the long run.
There are other types of quantitative strategies that neither I nor anyone else trading them would
write books about. These are usually very short-term strategies or strategies with low capacity that
would suffer or cease to be profitable if more capital comes into the same game. Medium- to longterm trend following however has massive liquidity and is very scalable, so it is not subject to these
concerns.
Then there is another reason for me to write about these strategies. I am not a believer in the blackbox approach in which you ask your clients for blind trust without giving any meaningful information
about how you achieve your returns. Even if you know everything that this book aims to teach, it is
still hard work to run a trend-following futures business and most people will not go out and start
their own hedge fund simply because they now understand how the mechanics work. Some probably
will and if you end up being one of them, please drop me an email to let me know how it all works
out. Either way, I would like to think that I can add value with my own investment vehicles and that

this book will not in any way hurt my business.


Acknowledgements
I had plenty of help in writing this book, both in terms of inspiration and support, and in reviewing
and correcting my mistakes. I would especially like to thank the following people who provided
invaluable feedback and advice: Thomas Hackl, Erk Subasi, PhD, Max Wong, Werner Trabesinger,
PhD, Tony Ugrina, Raphael Rutz, Frederick Barnard and Nitin Gupta.


1
Cross-Asset Trend Following with Futures
There is a group of hedge funds and professional asset managers who have shown a remarkable
performance for over 30 years, consistently outperforming conventional strategies in both bull and
bear markets, and during the 2008 credit crunch crisis showing truly spectacular returns. These
traders are highly secretive about what they do and how they do it. They often employ large quant
teams staffed with top-level PhDs from the best schools in the world, adding to the mystique
surrounding their seemingly amazing long-term track records. Yet, as this book shows, it is possible
to replicate their returns by using fairly simple systematic trading models, revealing that not only are
they essentially doing the same thing, but also that it is not terribly complex and within the reach of
most of us to replicate.
This group of funds and traders goes by several names and they are often referred to as CTAs (for
Commodity Trading Advisors), trend followers or managed futures traders. It matters little which
term you prefer because there really are no standardised rules or definitions involved. What they all
have in common is that their primary trading strategy is to capture lasting price moves in either
direction in global markets across many asset classes, attempting to ride positions as long as possible
when they start moving. In practice most futures managers do the same thing they have been doing
since the 1970s: trend following. Conceptually the core idea is very simple. Use computer software
to identify trends in a large set of different futures markets and attempt to enter into trends and follow
them for as long as they last. By following a large number of markets covering all asset classes, both

long and short, you can make money in both bull and bear markets and be sure to capture any lasting
trend in the financial markets, regardless of asset class.
This book shows all the details about what this group does in reality and how the members do it.
The truth is that almost all of these funds are just following trends and there are not a whole lot of
ways that this can be done. They all have their own proprietary tweaks, bells and whistles, but in the
end the difference achieved by these is marginal in the grand scheme of things. This book sheds some
light on what the large institutional trend-following futures traders do and how the results are created.
The strategies as such are relatively simple and not terribly difficult to replicate in theory, but that in
no way means that it is easy to replicate them in reality and to follow through. The difficulty of
managed futures trading is largely misunderstood and those trying to replicate what we do usually
spend too much time looking at the wrong things and not even realising the actual difficulties until it is
too late. Strategies are easy. Sticking with them in reality is a whole different ball game. That may
sound clichéd but come back to that statement after you finish reading this book and see if you still
believe it is just a cliché.
There are many names given to the strategies and the business that this book is about and, although
they are often used interchangeably, in practice they can sometimes mean slightly different things and
cause all kinds of confusion. The most commonly-used term by industry professionals is simply CTA


(Commodity Trading Advisor) and though I admit that I tend to use this term myself it is in fact a
misnomer in this case. CTA is a US regulatory term defined by the National Futures Association
(NFA) and it has little to do with most so-called CTA funds or CTA managers today. This label is a
legacy from the days when those running these types of strategies were US-based individuals or small
companies regulated onshore by the NFA, which is not necessarily the case today. If you live in the
UK and have your advisory company in London, set up an asset-management company in the British
Virgin Islands and a hedge fund in the Caymans (which is in fact a more common setup than one
would think) you are in no way affected by the NFA and therefore not a CTA from their point of
view, even if you manage futures in large scale.

DIVERSIFIED TREND FOLLOWING IN A NUTSHELL

The very concept of trend following means that you will never buy at the bottom and you will never
sell at the top. This is not about buying low and selling high, but rather about buying high and selling
higher or shorting low and covering lower. These strategies will always arrive late at the party and
overstay their welcome, but they always enjoy the fun in-between. All trend-following strategies are
the same in concept and the underlying core idea is that the financial markets tend to move in trends,
up, down or sideways, for extended periods of time. Perhaps not all the time and perhaps not even
most of the time, but the critical assumption is that there will always be periods where markets
continue to move in the same direction for long enough periods of time to pay for the losing trades and
have money left over. It is in these periods and only in these periods that trend-following strategies
will make money. When the market is moving sideways, which is the case more often than one might
think, these strategies are just not profitable.
Figure 1.1 shows the type of trades we are looking for, which all boils down to waiting until the
market has made a significant move in one direction, putting on a bet that the price will continue in the
same direction and holding that position until the trend has seized. Note the two phases in the figure
separated by a vertical line. Up until April there was no money to be made in following the trends of
the NZ Dollar, simply because there were no trends around. Many trend followers would have
attempted entries both on the long and short side and lost money, but the emerging trend from April
onwards should have paid for it and then some.
Figure 1.1 Phases of trend following


If you look at a single market at any given time, there is a very high likelihood that no trend exists at
the moment. That not only means that there are no profits for the trend-following strategies, but can
also mean that loss after loss is realised as the strategy enters position after position only to see
prices fall back into the old range. Trend-following trading on a single instrument is not terribly
difficult but quite often a futile exercise, not to mention a very expensive one. Any single instrument
or even asset class can have very long periods where this approach simply does not work and to keep
losing over and over again, watching the portfolio value shrinking each time can be a horrible
experience as well as financially disastrous. Those who trade only a single or a few markets also
have a higher tendency of taking too large bets to make sure the bottom line of the portfolio will get a

significant impact of each trade and that is also an excellent method of going bankrupt.
With a diversified futures strategy you have a large basket of instruments to trade covering all
major asset classes, making each single bet by itself almost insignificant to the overall performance.
Most trend-following futures strategies do in fact lose on over half of all trades entered and
sometimes as much as 70%, but the trick is to gain much more on the good ones than you lose on the
bad and to do enough trades for the law of big numbers to start kicking in.
For a truly diversified futures manager it really does not matter if we trade the S&P 500 Index,
rough rice, bonds, gold or even live hogs. They are all just futures which can be treated in exactly the
same way. Using historical data for long enough time periods we can analyse the behaviour of each
market and have our strategy adapt to the volatility and characteristics of each market, making sure
we build a robust and truly diversified portfolio.

THE TRADITIONAL INVESTMENT APPROACH
The most widely held asset class, in particular among the general public, is equities; that is, shares of
corporations trading on stock exchanges. The academic community along with most large banks and
financial institutions have long told the public that buying and holding equities over long periods of
time is a safe and prudent method of investing and this has created a huge market for equity mutual
funds. These funds are generally seen as responsible long-term investments that always go up in the
long run, and there is a good chance that even a large part of your pension plan is invested in equity


mutual funds for that very reason. The ubiquitous advice from banks is that you should hold a
combination of equity mutual funds and bond mutual funds and that the younger you are, the larger the
weight of the equity funds should be. The reason for the last part is that, although equities do tend to
go up in the long run, they are more volatile than bonds and you should take higher financial risks
when you are younger since you have time to make your losses back. Furthermore, the advice is
generally that you should prefer equity mutual funds over buying single stocks to make sure that you
get sufficient diversification and you participate in the overall market instead of taking bets on
individual companies which may run into unexpected trouble down the road.
This all sounds very reasonable and makes for a good sales pitch, at least if the core assumption of

equities always appreciating over time holds up in reality. The idea of diversifying by holding many
stocks instead of just a few companies also sounds very reasonable, given that the assumption holds
up that the correlation between stocks is low enough to provide the desired diversification benefits of
lower risk at equal or higher returns. Of course, if either of these assumptions turn out to be
disappointing in reality, the whole strategy risks falling like a proverbial house of cards.
In reality, equities as an asset class has a very high internal correlation compared to most other
types of instruments. The prices of stocks tend to move together up and down on the same days and
while there are large differences in overall returns between a good stock and a bad one, over longer
time horizons the timing of their positive and negative days are often highly related even in normal
markets. If you hold a large basket of stocks in many different countries and sectors, you still just hold
stocks and the extent of your diversification is very much limited. The larger problem with the
diversification starts creeping up in times of market distress or when there is a single fundamental
theme that drives the market as a whole. This could be a longer-term event such as a dot com bubble
and crash, a banking sector meltdown and so on, or it can be a shorter-term shock event like an
earthquake or a surprise breakout of war. When the market gets single-minded, the correlations
between stocks quickly approach one as everyone panic sells at the same time and then re-buys on the
same euphoria when the problems are perceived to be lessened. In these markets it matters little what
stocks you hold and the diversification of your portfolio will turn out to be a very expensive illusion.
Then again, if stocks always go up in the long run the correlations should be of lesser importance
since you would always make the money back again if you just sit on the stocks and wait a little bit
longer. This is absolutely true and if you are a very patient person you are very likely to make money
from the stock markets by just buying and holding. From 1976 to 2011 the MSCI World Index rose by
1,300%, so in 35 years you would have made over ten times your initial investment. Of course, if you
translate that into annual compound return you will see that this means a yield of just around 8% per
year. If you had been so unlucky as to invest in 1999 instead, you would still hold a loss 13 years
later of over 20%. Had you invested in 2007 your loss would be even greater. Although equities do
tend to move up in the long run, most of us cannot afford to lose a large part of our capital and wait
for a half a lifetime to get our money back. If you are lucky and invest in a good year or even a good
decade, the buy-and-hold strategy may work out but it can also turn out to be a really bumpy ride for
quite a low return in the end. Going back to the 1,000% or so made on an investment from 1976 to

2011, the largest drawdown during this period was 55%. Looking at the buy-and-hold strategy from a
long-term return to risk perspective, that means that in order to get your 8% or so return per year, you
must accept a risk of losing more than half of your capital, which would translate to close to seven
years of average return.


You may say that the 55% loss represents only one extreme event, the 2008 credit meltdown, and
that such scenarios are unlikely to repeat, but this is not at all the case. Let’s just look at the fairly
recent history of these so-called once-in-a-lifetime events. In 1974 the Dow Jones Industrial average
hit a drawdown of 40%, which took over six years to recover. In 1978 the same index fell 27% in a
little over a year. The same thing happened again in 1982 when the losses amounted to 25% in about
a year. From the peak in August 1987 to the bottom in October the index lost over 40%. Despite the
bull market of the 1990s, there were several 15–20% loss periods and when the markets turned down
in 2000 the index had lost about 40% before hitting the bottom. What you need to ask yourself is just
how high an expected compound return you need to compensate for the high risks of the stock markets,
and whether you are happy with single digit returns for that level of volatility.
If you do choose to participate in the stock markets through an equity mutual fund you have one
more factor to consider, and that is whether or not the mutual fund can match or beat the index it is
supposed to be tracking. A mutual-fund manager, as opposed to a hedge-fund manager, is tasked with
trying to beat a specific index and in the case of an equity fund that index would be something like the
S&P 500, FTSE 100, MSCI World or similar. It can be a broad country index, international index,
sector index or any other kind of equity index, but the task is to follow the designated index and
attempt to beat it. Most mutual-fund managers have very little leeway in their investment approach
and they are not allowed to deviate much from their index. Methods to attempt to beat the index could
involve slight over- or under-weights in stocks that the manager believes will perform better or
worse than the index, or to hold a little more cash during perceived bad markets. The really big
difference between a mutual-fund manager and a hedge-fund manager or absolute-return trader is that
the mutual-fund manager’s job is to follow the index, whether it goes up or down. That person’s job
is not to make money for the client but rather to attempt to make sure that the client gets the return of
the index and it is hoped slightly more. If the S&P 500 index declines by 30% in a year, and a mutual

fund using that index as a benchmark loses only 25% of the clients’ money, that is a big achievement
and the fund manager has done a very good job.
There are of course fees to be paid, including a management fee and sometimes a performance fee
for the fund as well as administration fees, custody fees, commissions and so on, which is the reason
why very few mutual funds manage to beat their index or even match it. According to Standard &
Poor’s Indices Versus Active Funds Scorecard (SPIVA) 2011 report, the percentage of US domestic
equity funds that outperformed the benchmark in 2011 was less than 16%. Worst that year were the
large-cap growth funds where over 95% failed to beat their benchmark. Looking over a period of five
years, from 2006 to 2011, 62% of all US domestic funds failed to beat their benchmarks. Worst in
that five-year period was the mid-cap growth funds where less than 10% reached their targets. The
picture that the S&P reports paint is devastating for the mutual-fund business. If active mutual funds
have consistently proved to underperform their benchmarks year after year, there is little reason to
think that this is about to change any time soon.
There are times when it’s a good idea to participate in the general equity markets by buying and
holding for extended periods of time, but then you need to have a strategy for when to get out of the
markets when the big declines come along, because they will come along. It makes sense to have a
portion of your money in equities one way or another as long as you step out of that market during the
extremely volatile and troublesome years, but I’m personally not entirely convinced about the wisdom
of putting the bulk of your hard-earned cash into this asset class and just holding onto it in up and


down markets, hoping for the best. For participating in these markets, you may also want to consider
investing in passive exchange-traded funds (ETFs) as an alternative to classic mutual funds, because
the index-tracking ETFs hold the exact stocks of the index at all times and have substantially lower
fees, making them track and match the index with a very high degree of precision. They are also very
easy and cheap to buy and sell as they are directly traded on an exchange with up-to-the-second
pricing.

THE CASE FOR DIVERSIFIED MANAGED FUTURES
There are many viable investment strategies that tend to outperform buy-and-hold equities on a

volatility adjusted basis and I employ several of them. One of the top strategies is trend-following
managed futures for its consistent long-term track record of providing a very good return-to-risk ratio
during both bull and bear years. A solid managed futures strategy has a reasonably high expected
yearly return, acceptable drawdown in relation to the yearly return and lack of significant correlation
to world equity markets, and preferably slightly negative correlation.
The list of successful traders and hedge funds operating in the trend-following managed futures
markets is quite long and many of them have been around for decades, some even from the 1970s. The
very fact that so many trend traders have managed not only to stay in business for this long period, but
to also make consistently impressive returns, should in itself prove that these strategies work.
Table 1.1 shows a brief comparison between the performances of some futures managers to that of
the world equity markets. As mentioned, MSCI World has shown a long-term yield of 8% with a
maximum drawdown (DD) of 55%, which would mean that over seven normal years of performance
were given up in that decline. This could be compared with funds like Millburn, which over the same
period had a return of 17% and only gave up 26% at the most, or the equivalent of one and a half
years only. Transtrend gave up even less of its return and even Dunn, which after a stellar track
record suffered a setback a few years ago, only lost four years of performance and still holds a much
higher compound rate of return than the equity index.
Table 1.1 Performance comparison


Looking at the funds’ correlation to MSCI World you should notice that none of them have any
significant correlation at all. This means that with such a strategy, you really don’t have to worry
about whether the world equity markets are going up or down since it makes little difference to your
returns. It does not mean that all years are positive for diversified futures strategies, only that the
timing of the positive and negative returns is, over time, unrelated to those of the equity market. The
observant reader might be asking if that does not make these strategies a very good complement to an
equity portfolio, and the answer is that it absolutely does, but we are getting ahead of ourselves here.

CRITICISM OF TREND-FOLLOWING STRATEGIES
Although certain criticisms of trend-following trading have some validity, there are other commonly

recurring arguments that may be a little less thought through. One somewhat valid criticism is that
there is a survival bias in the numbers reported by the industry. The argument is that the funds that are
part of the relevant indices and comparisons are only there because they did well and the funds that
did not do well are either out of business or too small to be part of the indices, and that this effect
makes the indices have a positive bias. This is of course a factor, much the same way as a stock can
be knocked out of the S&P 500 Index after it had bad performance and its market capitalisation
shrunk. Survival bias is a fact of life with all indices and it makes them all look a little better than
reality would dictate. This is not an asset class specific problem. Anyhow, the arguments made in this
book regarding the performance of diversified futures strategies are not dependent on the performance
of indices; the comparisons asset managers included consist of a broad range of big players, some of
which had some really difficult periods in their track records. There are some excellent aspects of
these strategies and there are some serious pitfalls and potential problems that you need to be aware
of. I deal with all of these in this book and have no intention of painting a rosier picture of the real
situation than my experience reflects. Doing so would be both counterproductive and also, quite
frankly, unnecessary.


Another common argument is that the high leverage makes the strategy too risky. This is mostly
based on a lack of understanding of the two concepts of leverage and risk, which are not necessarily
related. Defining leverage is a tricky thing when you deal with cross-asset futures strategies and
simply adding up notional contract values and dividing with the capital base simply does not cut it.
As I demonstrate and explain further on, having a million pounds’ worth of exposure to gold and
having a million pounds’ worth of exposure to the Euribor is a world apart in terms of actual risk.
While gold often moves several per cent in a day, a normal move in the Euribor would be a couple of
basis points. Sure, these futures strategies may have quite high notional contract exposures but don’t
go confusing that with risk. To be sure, these strategies can be risky, but buying and holding a
portfolio of stocks is not necessarily less risky.
Most trend-following futures strategies will need to sell short quite often, and often as much as you
buy long. Critics would highlight that when you are short you have an unlimited potential risk, which
again is a misunderstanding of how markets work. Just as with equities, you risk losing what you put

on the table but not more than that. While the pay-out diagram for a futures contract in theory has an
unlimited loss, unless you have an unlimited amount of margin capital in your account this is simply
not the case in reality. In my experience, it is harder to trade on the short side than the long side, but
that does not necessarily make it riskier, in particular when done in the context of a large diversified
portfolio. Rather, on the contrary, the ability to go short tends to provide a higher skew of the return
distributions and thereby increase the attractiveness as a hedging strategy.
Managed futures funds sometimes have large and long-lasting drawdowns. This is an absolutely
valid criticism and something you need to be very aware of before setting out on this path. People like
to hear percentage numbers, such as a common drawdown is 20% for example, but this is not really
helpful since you can tweak the risk factor up and down as you please by adjusting position sizes, as I
explain in detail in later chapters. The question should rather be whether the long-term return numbers
compensate for the worst drawdown scenarios and in this case it is hard to argue with the numbers.
Drawdowns are painful when they occur but to say that they are worse than for the classic buy-andhold equity alternative would be untrue. At the bottom of the equity bear market of 2008, based on
MSCI World, you would have lost 55% from the peak and gone back to the levels of the mid-1990s.
Losing almost 15 years of accumulated gains is practically unheard of for diversified futures
strategies, yet the buy-and-hold strategy is considered by many the safer alternative.
Of course, just because a strategy worked for the past 30 to 40 years does not necessarily mean it
has to work in the next decade or two. We are not dealing with mathematical certainties here and we
are not trying to predict the future. What we are doing is try to tilt the probabilities slightly in our
favour and then repeat the same thing over and over a large number of times. There will be years that
are very bad for trend followers and there will be very good years. Over time the strategy is highly
likely to produce strong absolute returns and to outperform traditional investment methods, but we are
dealing in probabilities and not in certainties. There are no guarantees in this business, regardless of
what strategy you choose. I don’t expect any major problems that would end the profitable reign of
trend-following futures trading, but it would be arrogant not to admit that the dinosaurs probably did
not expect a huge stone to fall from the sky and end their party either. Neither event is very likely but
both are quite possible.


MANAGED FUTURES AS A BUSINESS

This book primarily deals with how to trade trend-following futures strategies as a money manager,
trading other people’s money, and it would be fair to wonder why one would want to share the profits
with others. Some would take the view that once you have a good strategy with dependable long-term
results, you should keep it to yourself and only trade your own money. There are instances where this
may be true, in particular with strategies that are not scalable and have to be traded in low volume.
For a truly scalable strategy, however, there is no real downside to sharing the spoils and quite a bit
to be gained.
For starters, you need a large capital base to trade trend-following futures with sufficient
diversification and reasonably low volatility, and even if you master the trading side you may not
have the couple of million pounds required to achieve a high level of diversification with acceptable
risk. Pooling your money with that of other people would then make perfect sense. Given that you can
charge other people for managing their money along with your own makes the prospect even more
appealing, because it gives you an income while you do the same work you might have done yourself
anyhow, and apart from your own gains you participate in your clients’ trading gains as well.
If you go the hedge-fund route and accept external money to be pooled with your own and traded
like a single account, the overall workload increase is quite minor on a daily basis but your earning
potential dramatically goes up. If you choose to manage individual accounts you may get a little
higher workload on the admin side but a quicker and cheaper start-up phase and the economic upside
is essentially the same. For starters you will have a reasonably stable income from the management
fee which allows you to focus on long-term results. This strategy requires patience and if you feel
economic pressure to achieve profitable trading each month, this will not work out. There can be long
periods of sideways or negative trading and you need to be able to stick it out in those periods. Your
incentive should always be towards long-term strong positive returns while keeping drawdowns at
acceptable levels. As you get a percentage of the profits created on behalf of external investors, the
earning potential in good years vastly exceeds what you could achieve with your own money alone.
If you have US$100,000 and make a 20% return one year you just made US$20,000, which is great
for sure. But if you also have US$1 million of external investor money in the pot and charge a
management fee of 1.5% and a performance fee of 15%, you just made another US$30,000 in
performance fee as well as over US$15,000 in management fee. By doing the same trades on a larger
portfolio you make US$65,000 instead of US$20,000, and the beauty of managed futures trend

following is that it is very scalable and you can keep piling up very large sums of external money and
still trade basically the same way with very little additional work.
Managing external money means that you have a fiduciary responsibility not only to stick strictly to
the strategy you have been given the mandate to trade, but also to create relevant reports and analyses
and keep proper paperwork. This may seem like a chore but the added required diligence should be a
good thing and ensure that you act in a professional manner at all times.
The negative part with managing other people’s money is that you have a little less freedom,
because you need to stick to the plans and principles that you have sold to your investors. You likely
need to take lower risk than you would have done with your own account as well. Some traders who
just manage their own money may be fine with the prospect of losing 60–70% of the capital base in
return for potential triple-digit annual returns, but this is a very tough sell for a professional money


manager. Investors, and in particular institutional investors with deep pockets, tend to prefer lower
returns with lower risks.
The business of managing futures can be a highly profitable one if done carefully and with proper
planning. There are a large number of famous traders who have achieved remarkable results in this
field since the 1970s and the number of public funds in this space keeps increasing.
From a business point of view the deal is quite straightforward compared to most other types of
enterprises. A little simplified, it could be described in these steps:
1. Find clients to invest money with you.
2. Trade futures on their behalf.
3. Charge clients a yearly fixed fee for managing their money, usually 1–2%.
4. Charge clients a yearly performance fee if you make money for them, usually 10–20% of the
profits.
The nicest part of this business model is that it is no more difficult to manage US$20 million than to
manage US$10 million; your cost base would be more or less the same but your revenues would
double. This business model is very scalable and until you reach a very large asset base you can use
the same strategies in the same manner and just adjust your position sizes. Once you reach US$500
million to US$1 billion, you will for sure get a whole new set of problems when it comes to asset

allocation and liquidity, but that is rather a pleasant problem to have.
When first starting out most of us discover that the biggest problem we have is finding clients to
invest in a brand new manager with a brand new product. Unless your rich uncle Bob just retired and
has got a few millions he does not mind investing with you, it may be an uphill battle to get that first
seed money to get started. Before you start approaching potential clients you need to have a solid
product to sell them, that is, your investment strategy along with your abilities to execute it, and be
able to show them that you know what you are talking about. Designing an investment strategy is
where this book comes in and I hope you will have a good platform to build upon once you reach the
end.
There are two main paths for building a futures-trading business, as opposed to just trading your
own money:
Managed accounts: This is the traditional approach, where clients have accounts in their own
names and give a power of attorney to the trader to be able to execute trades directly on their
behalves. This is quite a simple approach in terms of setup and legal structures and it provides
the client with a high level of flexibility and security. Each account is different, and so the client
may have special wishes in terms of risk and such which the trader is usually able to
accommodate.
If this is not a desired feature and you wish to simplify trading, you can also get onto a managedaccounts platform for a bank or prime broker where you essentially trade one account and have
trades automatically pro rata split on the individual client accounts. Since the money is in the
client’s own account, the individual has the added flexibility of being able to view the account
status at any time or to pull the plug on the trading without any notices or otherwise intervene.
The client does not need to worry about dealing with a possible new Madoff, because there are
no middle men and the bank reports the account status directly to the client. For the money
manager, the managed-account solution can mean a little more administrative work at times than


if a hedge-fund type structure is employed.
Hedge fund: With this approach, there is one big account for all clients. Well, in practice there
may be several accounts at several banks, but the point is that all money from all clients is
pooled together in one pile and traded together. This greatly simplifies the business side when it

comes to handling client reporting and paperwork, but it requires a more complex legal structure,
sometimes with a combination of onshore and offshore companies.
Regardless of which of these two main paths you decide to take, you need to do some proper
homework on the pros and cons of either solution. More and more professional investors have a
preference for managed accounts because they reduce legal risks, but for most managed-account
setups you need larger amounts from each client than you would need for a hedge-fund setup. The
situation also varies a lot depending on where you and your potential clients are domiciled. Look into
the applicable legal situation and be sure to check what, if any, regulations apply. You may need
licences from the local regulators and breaching such requirements could quickly end your trading
reign.

DIFFERENCES BETWEEN RUNNING A TRADING
BUSINESS AND PERSONAL TRADING
The most important difference in managing a private account and a hedge fund or other professional
asset management is the importance of volatility. If your volatility is too high your investors are not
likely to stay with you. A temporary drawdown of 50% for a small private account might be
acceptable, depending on your risk appetite and expected rate of return, but it is not an easy sell to an
external investor.

Marketability of your strategy
When you trade your own account, and sometimes even manage accounts for trusted people, you can
trade on pretty much anything you think makes sense without having to convince anyone of how good
your ideas are. If you are truly a very strong trader and you have a stellar track record, you may be
able to do the same thing for a hedge fund or professional managed accounts, but the days of the black
box funds are mostly in the past. Simply telling prospective clients to just trust you and only hinting at
how your strategies work no longer makes for a good sales pitch. If you are dependent on raising
assets for your new fund, as most of us are, you need a good story to be able to paint a clear picture of
what your fund does and why it can make a big difference. This does not mean that you need to
disclose all your mathematics and hand over source code for your programs, but the principal idea of
what your strategy is about, what kind of market phenomenon you are trying to exploit and how you

intend to do so, needs to be clear and explainable. You also need to be able to explain how your risk
and return profile will look, what kind of return you are targeting and at what kind of volatility level.
Even if you have a good story for these aspects, you still need to be able to explain why your product
is unique and why the prospective client should not just go and buy another similar fund or hand
money to a different futures manager with a successful track record of many years.
You need to work on presentation and marketing. If you have solid simulations for your strategies,


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